Economic Outlook: Risks of an imminent recession?
Against the backdrop of uncomfortably high inflation, major central banks have remained steadfast in frontloading rate increases. On September 21, the US Federal Reserve raised policy rates for the third time this year by a quarter of a percentage point, bringing the Fed Funds rate to 3.00-3.25%. The UK followed swiftly with its own half a percentage point increase to 2.25% on September 22. Earlier in the month, the European Central Bank lifted the policy rate by 0.75 percentage points to 1.25%.
More importantly, central banks signalled their strong willingness to tolerate economic weaknesses, even recessions, in bringing inflation back to the target levels. While the risks of economic recession have increased in major advanced markets, the resultant demand destruction is deemed necessary to complete the task of taming inflation. As this round of inflation is mainly driven by supply-side factors (e.g. supply chain disruptions), using monetary policies alone to contain price pressure would be less efficient, particularly when fiscal austerity has yet to come through in most major markets.
In the US, the Fed is unlikely to start easing before the end of 2023. The EU is expected to keep tightening against the backdrop of soaring energy prices despite a high risk of recession. In the UK, the sharp depreciation of the sterling, amid concerns over high inflation and fiscal sustainability, will keep the BoE on a tightening bias for an extended period.
Recession risk has risen
The downward drift of manufacturing PMI in major markets has continued, and consumer confidence is weakening. The US ISM PMI hovers at just about 50 but was at the lowest since June 2020 (see Figure 1). In particular, the reports show a strong labour market, with hiring expanding at a robust rate with few indications of layoffs. In China, the official PMI dropped sharply in April but rebounded to above 50 in June. August’s reading was 53, close to the level observed through 2021.
Figure 1: China and US Purchasing Managers’ Index
Source: CEIC
Despite the positive manufacturing PMI readings, business sentiments have been clouded by the lingering pandemic, escalating geopolitical tension and aggressive central bank tightening. Since our last quarterly, the US yield curve has flattened further in a pattern reminiscent of previous economic recession episodes (see Figure 2).
Figure 2: US 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
Source: Federal Reserve Bank of St Louis. Shaded areas represent periods of recession.
At the same time, the Conference Board US Leading Economic Index (LEI) decreased by 0.3% in August 20022 to 116.2, after having dropped by 0.5% a month earlier. The six-month decline of the LEI is deemed to potentially signal a recession.[1]
These add weight to the view of an imminent US recession, even though the labour market remains tight and consumer spending is holding up well. That cannot be said of Europe or the UK, where recession risk is very high.
Where does Asia stand?
The weaknesses in the West will manifest as strong headwinds to Asian markets. Slacking export demand and dwindling capital and portfolio inflows will take a toll on many Asian markets. We will focus on two topics. First, how is the Chinese economy doing so far? Second is the vulnerability of the Asian market to a recession and quantitative tightening in developed markets.
1. China
China is somewhat free of some key challenges facing other advanced markets. Despite volatile global commodity and energy prices, it has reported consistently low headline inflation (August 2022: 3.1%). Economic growth has slowed significantly but still outpaced most advanced markets.
Yet there is no denying that China has entered a soft patch in growth. For instance, real GDP rose by a meagre 0.4% year-on-year in Q2 this year. Indeed, based on a typical growth rate of 5-6%, anything below 3% can be considered recessionary in the Chinese context. While export growth has largely maintained robust growth in 2022, consumption has weakened, and the correction in the property market has deepened (see Figure 3). Unemployment has also risen tangibly, particularly for the younger age group (19.3% urban unemployment rate in Jun for those aged 16-24).
Figure 3: Year-to-date % changes in building sold
Source: CEIC
The weakness has prompted the government to implement more reflationary policies. The State Council released a set of 33 supportive measures at the end of May.[2] Local governments also issued their own set of supportive policies, e.g. shanghai has issued a set of 50 policy measures to support the local economy.[3] Given the time lag between policy implementation and the showing up of their impacts, it is fair thus to expect some tangible improvement in growth figures towards the end of this year. However, the recovery will likely remain fragile and volatile, particularly in terms of private domestic consumption.
Overall, the reflationary fiscal and monetary efforts will help to arrest the slowing growth momentum, but given tight pandemic measures in place, weakening external demand, and lead time for stimulus to filter through, growth in the rest of 2022 will remain subdued. For the year as a whole, growth is likely to average at around 3%.
2. Will there be a repeat of the 2013 Taper Tantrum in emerging markets?
Monetary tightening and a strong US dollar are taking a heavy toll on financial markets. A key concern is the capital outflow and impact on Asian markets. The 2013 Taper Tantrum has helped to highlight the vulnerability of the Asian market to volatile capital flows. Are they better prepared now? In the second quarter of 2022, emerging Asian markets collectively saw an estimated USD40 billion outflow in equity investment.[4] All regional currencies have depreciated against the greenback, from a year-to-date drop of 4% for the Vietnamese dong to a 15.6% decline in the Philippines peso. Furthermore, the region is now more indebted than before. The IMF estimated that Asia’s share of global debt has increased from 25% before the GFC (2009) to 38% post-COVID.[5] Yet, the financial market condition remains stable mainly for the following reasons.
- Better balance of payment positions: Fragile five current account balance as % of GDP has improved from -4.0% in 2013 to an estimated -1.4% in 2021.[6]
- Greater emerging market buffers against external shocks, particularly through swap arrangements among central banks
- Inflation in Asia is more moderate, which supports real rates
Concluding remarks
The weakening growth outlook of advanced markets increasingly weighs on Asian markets. High inflation will likely persist until the monetary condition tightens sufficiently to compensate for the still very loose fiscal stance. In addition, geopolitical tension continues to escalate, thus adding to inflationary pressure (supply-side) and dampening investors’ confidence.
Asia will be shielded from part of these headwinds but not immune. A strong US dollar will funnel global inflation to Asia through higher imported prices. Asia will benefit from lower export prices but not at a time when every currency is depreciating against the US dollar – lower export prices do not necessarily translate into better export competitiveness. Earlier efforts to promote domestic consumption and intra-Asia trade/investment will pay off in terms of more diversification in growth.
[1] For more details, see conference-board.org/topics/us-leading-indicators.
[2] See notice from China State Council: http://www.gov.cn/zhengce/content/2022-05/31/content_5693159.htm.
[3] Source: Action Plan of Shanghai for Accelerating Economic Recovery and Revitalisation, Government of Shanghai.
[4] Source: Foreign Investors Drained $40 Billion From Emerging Asia Last Quarter, and It Could Get Worse, Bloomberg, July 4, 2022.
[5] See ”Asia’s Economies Face Weakening Growth, Rising Inflation Pressure”, IMF Blog, July 28, 2022.
[6] How vulnerable is emerging market debt to Fed tapering in 2022? Franklin Templeton, December 2021.
